FX cost measurement: Benchmarking trading costs

According to Jeremy Smith, head of financial services at market intelligence firm McLagan (Z/Yen): “Most non-financial services industries have long-standing measurements of efficiency, from profitability in sawmills in the US to cost benchmarking for mobile phone operators in Europe. However, formal efficiency measurement in wholesale financial markets is much less developed.” Smith argues in his report Cost per trade and STP benchmarking that there are several reasons for this, including the constant development of new products, and in foreign exchange, particularly, the use of multiple platforms, both internally and externally. In addition, many financial market participants have traditionally focused more on driving their businesses forward, which typically means prioritizing the front office, rather than analysing back-office metrics.

The paper was commissioned by post-trade vendor Wallstreet Systems as part of its pre-marketing for its electronic services network (ESN) service, launched in October. The reason was that Wallstreet had found that there were wide discrepancies in how people measured their post-trade costs.

“Everybody was talking apples and oranges here,” says Tony White, managing director of Wallstreet. “The big guys have been involved in studies and peer assessments but once you get out of the Euromoneytop 20, some banks were adding stuff in that others were leaving out and vice-versa. What we wanted to do was to come up with a correct methodology that anyone should apply when calculating this so they could compare like with like. We wanted something to verify our value proposition. It’s the first stab in getting an industry-wide methodology approved.”

Understanding

Smith says that the first stage in the process is to understand what it is that is being measured. To do this requires a careful definition of scope. “In many banks, the activities covered by the operations groups differ significantly,” he says. “For example, in some banks the creation and matching of confirmations is processed in operations, whereas in other banks, it is done in either a specialized middle office or in a front-office support group.”

Once this is done, a set of benchmarks should be defined. Smith says these typically include: cost per trade (costs divided by trade count); operational throughput (volume divided by headcount); cost per head (cost divided by headcount); cost economy of scale (cost per trade measured relative to volume); and operational throughput economy of scale (operational throughput measured relative to volume).

However, to add to the complications, there are substantial differences in the way cash and derivative trades are settled. Ultimately, though, this should not hinder the development of post-trade benchmarks. An obvious question, though, is: does any of this actually matter?

McLagan (Z/Yen) presented firm evidence of the impact of economies of scale using the example of a big FX player whose average daily ticket volume has risen from 6,500 to an estimated 200,000 in 2008. Although it has had to invest to cope with this increase in business, it has seen a substantial lowering of its processing costs per ticket (see table). Although such savings might be out of the reach for tier 2 and tier 3 banks, having a fuller understanding of their true costs of trading should help them to at least make their decisions about how to run their post-trade functions. Naturally, Wallstreet and other vendors will hope they chose the new outsourcing models that are emerging.

Ultimately, though, their decisions will be driven by profitability. “It always comes down to P&L. It’s as simple as that,” says White.

“Traders like to think the difference between their buy and sell price is the P&L but that neglects the operational cost to the banks and that’s expensive. Processing is not cheap and you have to get the volume through to pay for investment and staff.